Objectives and Game Plan
-
-
-
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Understand some key concepts of Financial Accounting
Appreciate the differences between cash basis and
accrual accounting
Develop a mental model for classifying types of
accruals
Practice the basic bookkeeping model
15.514 2003
Session 2
Important Financial Accounting Concepts
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Conservatism: not the same as pessimism
Materiality: Benefit/cost trade-off
Consistency: Contrast with uniformity
Comparability
Verifiability
Revenue Recognition
Matching Principle: Matching Efforts (costs) with Benefits
(revenue)
• Further, we will make assumptions about the Economic Entity,
its ability to survive as a Going Concern, and the Fiscal Period
(which need not be the calendar year)
15.514 2003
Session 2
Key Conflict: Relevance v. Reliability
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Example: How should we value one-of-a-kind assets,
like one of Intel’s wafer fabrication plants?
15.514 2003
Session 2
Key Conflict: Relevance v. Reliability
-
Example: How to value one-of-a-kind assets?
• Financial accounting stresses Objectivity: Verifiable
and reliable information.
• Does not mean accounting is “cut and dried.”
• Still ample room for managerial judgment when estimating future effects under “objective rules.”
15.514 2003
Session 2
The Balance Sheet Equation
Assets
=
Liabilities
+
Shareholders’ Equity
Assets
-
Liabilities
=
Shareholders’ Equity
“own”
“owe”
“owners’ share of the business”
(book value, residual claim)
15.514 2003
Session 2
Accounting in a Single-Period Word is “Easy”
- Cash
Invested
0
-
+ Cash
Returned
1
Example: Shipping Expeditions in the 15th Century
• Ship sold at end of voyage: finite project life
• No information available until ship returns
• Income is simply difference between cash out and
cash in
15.514 2003
Session 2
Accounting in a Multiperiod World is “Difficult”
Cash Invested
0
1
2
3
4
5
6
…
Cash Returned
-
-
No pre-determined end to firm's life - going concern
Cash invested and generated at multiple points in time
Subsequent actions affected by prior results - feedback
Monitoring by external investors: evaluate investment, retain/reward
management
Accrual accounting: focus on measuring performance in a given time
period, independent of cash effects.
15.514 2003
Session 2
Principals of Accrual Accounting
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-
-
An attempt to measure firm performance regardless of when cash
is exchanged
Revenue Recognition:
• Earnings process substantially complete
• Cash collection reasonably assured
The Matching Principle for Expenses:
• Match efforts to the benefits generated
• Capitalize expenditures that will benefit future periods,
expense as benefits are realized
• Recognize liabilities when efforts benefiting the current period
require cash payment in the future
15.514 2003
Session 2
Cash Collection v. Revenue Recognition
Prior Period
Cash received
concurrent
with earning
revenue
Cash received
before earning
revenue
Cash received
after
earning
revenue
Current Period
Subsequent Period
+ Cash (A) =
+ Revenue (SE) �
Income Statement
+ Cash (A) =
+ Deferred
Revenue (L)
0=
- Deferred Revenue (L)
+ Revenue (SE) �
Income Statement
+ Accounts Receivable (A) =
+ Revenue (SE) �
Income Statement
+ Cash (A)
- A/R (A) = 0
Note: Deferred Revenue can also be called Advances from Customers. Both names signify
that cash has been received for a service or product that hasn't been delivered.
15.514 2003
Session 2
Cash Payment v Expense Recognition
Prior Period
Cash paid
concurrent with
using resource to
generate revenue
Cash paid
before
using resource to
generate revenue
Cash paid
after
using resource to
generate revenue
Current Period
Subsequent Period
- Cash (-A) =
+ Expense (-SE) �
Income Statement
- Cash (-A)
+ Productive
Asset (A) = 0
- Productive Asset (-A) =
+ Expense (-SE) �
Income Statement
0=
+ Accrued Liability (L)
+ Expense (-SE) �
Income Statement
- Cash (-A) =
- - Accrued
Liability (-L)
Note: The "Productive Asset" could be inventory, Prepaid Insurance, PP&E, etc. In the case of
PP&E, we would reduce the value of the asset through the contra-asset Accumulated
Depreciation. The"Accrued Liability" could be Accounts Payable, Accrued Wage Expense,
Interest Payable, etc
15.514 2003
Session 2
Temporary v Permanent Accounts
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Permanent Accounts:
• Appear on the Balance Sheet
• Start each period with the ending balance from the
prior period
Temporary Accounts:
• Appear on the Income Statement
• Start each period with a balance of $0
• Are closed at the end of the period to the Income Summary to compute Net Income for the period
15.514 2003
Session 2
Handling Temporary Accounts in the Balance Sheet Equation (BSE) Format
Net Income = Revenues - Expenses + Gains - Losses
End. Ret. Earn. = Beg. Ret. Earn. + NI - Div
Therefore...
Revenues and Gains ultimately Increase Ret. Earn.
Expenses and Losses ultimately Decrease Ret. Earn.
We’ll record Income Statement components directly to the
Permanent Account, Retained Earnings, with a note about the
reason and recognize that this is a short-cut around the use of
Temporary Accounts
15.514 2003
Session 2
Exercise E5-18: Peters Company
See Example E4-19: Peters Company on pages 163-4 in the course textbook.
15.514 2003
Session 2
Exercise E5-18: Peters Company, Year 1
Cash + AR + PPRent + INV = AP + WgsPble + CC + RE
BB
1
Total Assets =
Liab + SE =
15.514 2003
Session 2
Exercise E5-18: Peters Company, Year 2
Balance
Sheet
BB
Cash + AR + PPRent + INV = AP + WgsPble + CC + RE
26
4
6
5
10
4
24
3
1
15.514 2003
Session 2
Exercise E5-18: Peters Company (continued)
Performance Measure
Year 1
Year 2
Total
Net Income……………
Net Cash Flow from
Operations…………….
15.514 2003
Session 2
Key Points
-
-
-
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Relevance of Accounting Measures depends on the
decision context
Most relevant measures are sometimes the least reliable:
a major trade-off in accounting
Accrual Accounting attempts to measure performance,
regardless of when cash is affected
• Tables on slides 8 and 9 provide a framework for
thinking about the accrual process
Balance Sheet Equation (BSE) as a tool for
understanding events' impacts on the Financial
Statements
15.514 2003
Session 2